U.S. financial services can expect more Dodd-Frank in 2012, not less

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NEW YORK, Dec.16 (Thomson Reuters Accelus) – When congressman Barney Frank announced he would not seek another term, enemies were quick to predict the demise of the wide-rangingÂ financialÂ reform act that the Massachusetts Democrat penned with former Connecticut Senator Chris Dodd. These pronouncements are not just premature, but according to regulatory experts, probably wrong. Unless there is a real seismic political shift to the right after the 2012 elections, they say, the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 will survive, perhaps with a little tinkering, and firms had better be prepared to deal with it.

Dodd-Frank will only face a real threat if the Republicans take the White House and a majority in the U.S. Senate, while hanging on to the House of Representatives. Right now, with former House Speaker Newt Gingrich the latest to surge to the top of the Republican pack of presidential candidates, the likely outcome of November presidential elections is far from clear. If President Barack Obama, who signed Dodd Frank into law, stays in office, heÂ canÂ use his veto power to try to protect Dodd-Frank.Ernest Patrikis, a bank advisory partner at White & Case in New York told Thomson Reuters: “The Republicans in the HouseÂ canpass all the amendments to Dodd-Frank they want. None of them will be passed in the Senate. We’ll have to wait for the results of the 2012 elections to see if there’s enough for a change.”

If the Republicans do sweep into power and fulfill their promise to gut or repeal Dodd-Frank, many academics and lawyers argue that could actually do the U.S. markets a lot of harm. The legislation may not be perfect, but it was clear from the crisis thatfinancialÂ regulation needed to be redone and on the whole, Dodd-Frank is a positive step forward, they say.

Banks are already starting to realign themselves to the new reality. They’re coming up with living wills. They’re getting rid of their proprietary trading businesses. They’re preparing for capital raises. They’re working off their bad assets. There isn’t any sense in dumping Dodd-Frank now. That kind of reversal would only bring chaos to the markets.

Jeff Berman, a partner at Clifford Chance in New York said: “The recognition in Dodd-Frank of managing systemic risk as a policy goal of equal importance of the deposit insurance funds and the protection of the investing public is something that is now part of the market expectation and could only be disruptive if it were overturned in a thoughtless and wholesale fashion.”

FirmsÂ canÂ forget about that wish list they have of parts of the Act they’d like to see dropped. The Volker rule, the ConsumerFinancialÂ Protection Bureau (CFPB), all the various derivatives rules, the Durbin ruleâ€”they’re all here to stay. What firms need to start thinking about is the part of Dodd-Frank that have yet to be spelled out like the enhanced prudential supervision rules soon to be published by the Federal Reserve and the full impact of the little-known Office forÂ FinancialÂ Research (OFR) now housed in the U.S. Treasury. The future will bring more Dodd-Frank-related rules and regulations, not less.

WIGGLE ROOM

With theÂ financialÂ gloom and doom lingering, the millions of dollars banks spend on lobbying U.S. politicians probably would have been better saved for a rainy day. Bankers’ bucks do not have as much currency in Washington anymore. That means banks will not be able to buy their way out of Dodd-Frank.

Patrikis said: “The banking industry still doesn’t have a lot of credibility on the Hill. It may for some Republicans, but if you’re a lobbyist for a banker, you’ve got a tough job.”

However, when it comes to some of the details in Dodd-Frank, especially parts of the Volker rule and some of the derivatives rules that many believe to overreaction by lawmakers, there may be a little room for changes. The question is will regulators take the opportunity to make those tweaks in the rulemaking process?

One New York-based lawyer said: “I think there’s a lot of wiggle room. Unfortunately the agencies haven’t taken it. There’s clearly a lot of disagreement among the agencies. They’re supposed to be acting in concert on this, and they’re not. Â So we’ve got this rulemaking and it’s just evident on the face of it that theyÂ can’t agree on because everything’s posed as a question instead of a proposal.”

Whether part of the Volker rule restrictions that lump private equity in with proprietary trading and hedge fund activities are relaxed or eliminated remains to be seen. There could be some easing of the tough rules around derivatives trading, too. For example, one part of Dodd-Frank that lawyers call a plain mistake is the rule that says that banks with access to Federal Reserve credit cannot deal in some derivatives. There are some practical exceptions, like interest-rate swaps, thatÂ canÂ be undertaken by FDIC-insured banks. However, a branch of a foreign bank in the U.S. is not FDIC-insured and does not get the benefit of the exception. Blanche Lincoln, the former Democratic senator who proposed this rule, has said it is a mistake, but no move has been made to remedy it.

Patrikis said: “It’s still a mistake and there hasn’t been a bill introduced to fix it. People I talk to at the Fed could care less. That’s low on their priorities.”

MARGIN ON DERIVATIVES TRADES

Another element of Dodd-Frank that has derivatives dealers wringing their hands is the requirement that they post margin on all over-the-counter trades. The aim was to prevent banks from building up big speculative positions in derivatives without the appropriate capital safeguards. While the act does allow for a few exceptions to the rule, banks object to the lack of differentiation between speculative trades and hedging transactions. They don’t want to be penalized for hedging activities that could garner a margin requirement.

Matthew Richardson, Charles E. Simon professor ofÂ financialÂ economics at New York University’s Stern School of Business told Thomson Reuters: “That’s something [regulators] have to solve. They tried to have exemptions, for example, but it’s very difficult to write simple rules, which would be best in this case. What they’re struggling with both here and abroad is being able to differentiate between risk mitigation and risk taking. We will probably have a second-best solution that will decrease the amount of derivatives in the world, but maybe that’s the best weÂ canÂ do.”

It may not make a lot of economic sense for firms to put up margin on what they might consider to be a risk management trade and there still yet be some room for refining the language of this particular requirement. However, academics and lawyers make the observation that regulation of the derivatives market is going to happen. Any claw back the industry achieves is likely to be a small victory.

ENHANCED PRUDENTIAL SUPERVISION

Guidelines on enhanced prudential supervision from the Federal Reserve are the next big thing expected as U.S. regulators implement Dodd-Frank. The announcement has been delayed until next year mainly due to the volume of new regulation the Fed is dealing with at the moment. However, it is expected that what the Fed will announce is new capital requirements. These requirements will apply to the so-called systemically importantÂ financialÂ institutions (SIFIs) that have over $50 billion in capital, non-bank SIFIs and potentially smaller banks in the region $10 billion in capital.

Patrikis said: “Now dealing with the capital is statutory. It’s Dodd-Frank. Everyone’s expecting it to come. Whereas with Basel II they could drag their feet because it was only the Basel supervisors they had to worry about.”

In addition to capital requirements, there could be a pronouncement on Basel III implementation, leverage, liquidity and counterparty risk. It could result in the U.S. having tighter capital standards that required by Basel III, similar to those in Switzerland and the United Kingdom.

OFFICE OF FINANCIAL RESEARCH

Firms also need to start preparing to supply data to the OFR. This unit was created by Dodd-Frank to collect data fromÂ financialÂ institutions so that in the event of a crisis or bank failure, regulatorsÂ canÂ hopefully gain a better insight into the shape of the event. The OFR will also contribute to the monitoring ofÂ financialÂ stability and systemic risk at theFinancialÂ Stability Oversight Committee (FSOC).

Richardson said: “One of the issues with the crisis was that there was a lack of information and data available to regulators leading into the crisis a lack of data about the health ofÂ financialÂ firms so regulators and policy makers couldn’t really make informed decisions. No one had any clue who was exposed to whom. There is still almost zero information on that.”

The OFR currently is working on a system of identifying numbers for every firm and determining what kind of data it needs to collect. Ultimately, it will use supercomputers so that the next time there is a bank failure akin to Lehman Brothers, someone in the Treasury, will be able to see lists of all the counterparty trades, for example, logged with the bank.

Richardson added: “If you look at the Act and what it’s trying to do, the OFR is an example of a low-cost potentially big pay-off item. When you have the FSOC or the Fed making big decisions you’d like those decisions not to be based only on theory or what seems right, but also backed by data. It’s a necessary condition to be able to make informed decisions.”

Some bankers view the OFR as further and unnecessary government intrusion into their business. They also worry about revealing what they consider to be proprietary and sensitive information. Banks may not like it, but they will be required by law to supply any data the OFR requests and in future will likely need a dedicated team to handle this requirement.

NEVER AGAIN

The reality is regulators are anxious to avoid another crisis of the scale and cost of the one kicked off by Lehman Brothers’ collapse in 2008. In their determination, regulators and lawmakers are less willing to concede to the banking industry’s criticisms of Dodd-Frank. Instead, their message is: never again will banks be permitted to fail in such a way that their losses are borne by the public purse, while their gains are paid out in the form of lavish salaries, benefits and bonuses.